Stephenson Real Estate Recapitalization

Mini Case: Stephenson Real Estate Recapitalization

CASE OVERVIEW

* Stephenson Real Estate Company was founded 25 years ago by current CEO, Robert Stephenson.

* The company purchases real estate and rents the property to tenants.

* The company shown profit every year for the past 18 years.

* Robert is extremely averse to debt financing due to prior experience of bankruptcy.

* As a result, the company is entirely equity financed.

* 15 million shares of common stocks outstanding traded at $35.20 per share.

* Stephenson is evaluating a plan to purchase a huge tract of land for $110 million.

* It is expected to increase annual pretax earnings by $27 million in perpetuity.

* Cost of capital = 12.5%

* Using debt: Bonds at par value with an 8% coupon rate.

* Jennifer (new CEO) feels optimal capital structure is 70% equity and 30% debt.

* Corporate tax rate = 40%

1. If Stephenson wishes to maximize its total market value, would you recommend that it issue debt or equity to finance the land purchase? Explain.

To maximize the value of the firm, Stephenson should use debt to finance the 110 million land purchase. The benefit of using debt financing is that the interest payments are tax deductible. Therefore, debt in the firm’s capital structure will decrease the firm’s taxable income. Hence, it creates a tax shield that will increase the overall value of the firm.

2. Construct Stephenson’s market value balance sheet before it announces the purchase.

Market value of equity = $35.20 (15,000,000)

= $528,000,000

Balance sheet before the land purchase:

Market Value Balance Sheet |

Assets | $528,000,000 | Equity | $528,000,000 |

Total Assets | $528,000,000 | Total Debts & Equity | $528,000,000 |

3. Suppose Stephenson decides to issue equity to finance the purchase:

a) What is the net present value of the project?

As a result of the purchase, pretax earnings expected to increase...